Deferred Gratification
The long-awaited final regulations under Section 409A of the Internal Revenue Code, which impose a set of complicated rules on deferred compensation arrangements, were issued in April 2007. For these purposes, deferred compensation is defined as a legally binding right in which vested benefits are paid at a future time. The new rules generally apply to deferred compensation that was contributed by the participant (or on her behalf) or otherwise first became vested after December 31, 2004.
If an arrangement constitutes deferred compensation, certain requirements under Section 409A are imposed, including but not limited to the establishment of determinable date(s) of payment, restrictions on the timing of certain deferral elections, and restrictions on a participant’s ability to modify elections regarding the timing or form of payment. Moreover, such arrangements must be set forth in writing.
Certain owners and officers of publicly traded companies are also subject to a six-month delay in receipt of payments from Section 409A arrangements that are triggered by a separation from service. Significantly, except for the six-month delay on payments, described above, the application of the rules is not limited to executives, but also extends to rank-and-file employees who are entitled to any form of deferred compensation, unless subject to an exemption under Section 409A. The exempted arrangements include certain separation pay plans, tax-qualified plans (Section 401(k) and 401(a) plans), Section 403(b) plans, Section 457(b) plans, short-term deferral arrangements, and certain death benefit or disability benefit arrangements.
Since the issuance of the final regulations, I have received several calls from plan advisers about the scope of severance benefits and whether such benefits are subject to Section 409A. A severance program that promises a benefit upon an employee’s termination of employment potentially is subject to Section 409A unless it meets an exception. The final rules provide an exclusion from Section 409A for severance payments resulting from an involuntary separation from service if the payments do not exceed the lesser of (i) two times the compensation limit under Section 401(a)(17) of the Internal Revenue Code for the year in which the employee separates from service (in 2007, the Section 401(a)(17) limit is $225,000) or (ii) two times the employee’s annual rate of compensation for the taxable year prior to the taxable year in which the separation from service occurs. In addition, the severance payments must be payable no later than the end of the second taxable year following the year in which the employee separates from service.
One of the most noteworthy changes in the final regulations is that severance payments (which meet the above requirements) will be excluded up to the above dollar limitation under Section 409A, even if the aggregate amount of the severance payments is in excess of the above limits. For example, if an employee’s annualized rate of pay in 2006 were $250,000 and if she is owed a severance payment of $500,000 upon her involuntary termination in 2007, so long as the two-year cap on the payout period is met, the portion of the payment equal to $450,000 (the limit available under the separation pay exclusion under Section 409A) would be excluded from Section 409A leaving only the remaining $50,000 subject to the Section 409A rules. If the employee in our example is otherwise subject to the six-month delay in payment (discussed above), the $450,000 could be paid to her without regard to the six-month rule, but the remaining $50,000 payment could only be paid to her following the expiration of the six-month period.
The IRS has provided welcome guidance on Section 409A with the issuance of the final regulations. If you are assisting clients with any benefits that may be subject to Section 409A, it is not too early to begin a process to inventory the arrangements that have been created by your clients since, if necessary, the deadline for amending such arrangements to comply with the final regulations is December 31, 2007.
Quana C. Jew is a partner at the law firm of Arent Fox, focusing on ERISA, employee benefits, and executive compensation. Quana has served as a guest lecturer in the employee benefits area for various law school, bar seminar, and employee benefits-related organizations. She also serves on the Advisory Board of the Women’s Pension Exchange. Most recently, Washingtonian magazine named Quana as one of Washington’s best tax lawyers.